APPENDIX 5: GEOMETRICAL ANALYSIS OF CONSUMER EQUILIBRIUM

SUMMARY TO APPENDIX
1. An indifference curve depicts the points of equally desirable consumption bundles.
The indifference contour is usually drawn convex (or bowl-shaped) in accordance with
the law of diminishing relative marginal utilities.
2. When a consumer has a fixed money income, all of which she spends, and is
confronted with market prices of two goods, she is constrained to move along a
straight line called the budget line or budget constraint. The lines slope will depend
on the ratio of the two market prices; how far out it lies will depend on the size of her
income.
3. The consumer will move along this budget line until reaching the highest attainable
indifference curve. At this point, the budget line will touch, but not cross, an
indifference curve. Hence, equilibrium is at the point of tangency, where the slope of
the budget line (the ratio of the prices) exactly equals the slope of the indifference
curve (the substitution ratio or the ratio of the marginal utilities of the two goods).
This gives additional proof that, in equilibrium, marginal utilities are proportional to
prices.
4. A fall in income will move the budget line inward in a parallel fashion, usually causing
less of both goods to be bought. A change in the price of one good alone will, other
things being constant, cause the budget line to pivot so as to change its slope. After a
price or income change, the consumer will again attain a new tangency point of
highest satisfaction. At every point of tangency, the marginal utility per dollar is equal
for every good. By comparing the new and old equilibrium points, we trace the usual
downward-sloping demand curve.
CONCEPTS FOR REVIEW
Indifference curves, slope or substitution ratio, budget line or budget constraint, convexity of
indifference curves and law of diminishing relative marginal utilities, optimal tangency ratio:
PF/Pc = MUF/MUC

QUESTIONS FOR DISCUSSION

1. Draw the indifference curves (a) between complementary goods like left shoes and right
shoes and (b) between perfect substitutes like two bottles of cola sitting next to each
other in the store.
An indifference curve depicts the points of equally desirable consumption bundles. The
indifference curve for two goods represents the combinations of the two goods for which
the consumer is indifferent; that is the consumer does not mind what combination of the
two goods they buy.
For example, imagine a consumer who chooses between bread and shirts:

Indifference Curve
7
6

Bread

5
4
3

Here, the consumer is indifferent as

to whether they buy 6 loaves of
bread and 1 shirt, or 3 loaves of
bread and 2 shirts, or 2 loaves of
bread and 3 shirts. They dont mind
what combination of bread and
shirts they buy if the combination is
along the indifference curve.

As the consumer moves down the

indifference curve, from the top
1
left, they give up a certain amount
of bread for a certain amount of
0
0
1
2
3
4
5
6
shirts. For instance, moving from
the first point to the second, the
Shirts
consumer gives up 3 loaves of bread
(from 6 to 3) for 1 extra shirt (from
1 to 2). The slope of the curve therefore gives the substitution ratio or the marginal rates
of substitution, which in laymans term is how much of one good are you willing to give
for an extra unit of another. This gives the ratio of the marginal utilities of the two
goods ( ). If the consumer gives up 3 loaves of bread for an extra shirt
then the extra shirt must be worth 3 times one loaf of bread to them.
2

The curve slopes downwards, and is bowl-shaped, because each new shirt gives less utility
than the last, and so the consumer is willing to give up less bread for it. This is the law of
diminishing relative marginal utilities.
The consumer would be even happier if they could buy more bread and shirts in total, say
6 loaves of bread and 2 shirts. There will still, however, be other combinations of bread
and shirts that gave this same, higher level of utility, and so the consumer would be
indifferent between these combinations. On the graph, another indifference curve can be
plotted, up and to the right from the first. Indeed a whole family of indifference curves
(labelled U1, U2, and U3), representing levels of utility, could be plotted on an indifference
map:

Moving along an indifference curve

means the consumer neither gains
nor loses utility. Moving across the
indifference curves, to the top right
of the diagram, means the
consumer gains utility.

A Family of Indifference Curves

7
6

Bread

5
4
3

The map is rather like an Ordnance

Survey map with the curves being
contour lines of equal elevation.
Moving along the contours means
you neither go up nor down, but
moving across them means you
head up or down a hill.

U3

U2

U1
0
0

Shirts

(a) For two complementary goods, like left shoes and right shoes, a consumer will always
want them in pairs. A left shoe is no good without a right show and vice versa. You will
always want an equal amount of each.

If they bought a second right shoe,

they would gain no extra
satisfaction, nor for a third or
fourth right shoe. So, if they have
one left shoe, they are indifferent
as to how many right shoes they
have, as long as they have one.

Indifference Curve
5
4

Left Shoes

If a consumer has one left shoe,

they will want one right shoe. On a
pair of axes, with left shoes on the
vertical axis and right shoes on the
horizontal axis, this situation
where the consumer buys one left
shoe and one right shoe is shown
graphically (see right).

One left shoe

and one right
shoe

3
2
1
0
0

Right Shoes

Graphically, this is shown by drawing a line that extends rightwards horizontally from our
point.
By the same logic, once we have one right shoe, we are indifferent to how many left shoes
we have. Graphically, this is shown by drawing a line that extends upwards vertically from
the original point.

Combining the horizontal and

vertical lines, each extending from
the original point gives the
indifference curve (see left).

Indifference Curve
5

Left Shoes

The indifference curve for perfect

complements, such as left shoes
and right shoes, is an L-shape. The
elbow of the L lies on the point
where the number of each type of
shoe is equal to each other and to
the number of that type of shoe
with the least amount.

3
2
1
0
0

A similar argument would apply for

two pairs of shoes. Once you had
two left shoes, as long as you had
two right shoes, any extra amount of right shoes would be useless and would leave you
indifferent. The argument extends to three, four, five pairs etc. A whole family of
indifference curves can be plotted (see below right).

Right Shoes

Each indifference curve is Lshaped. The elbows all lie on the

45 line, where the number of
each type of shoe is equal to one
another and to the number of that
type of show with the least
amount.

A Family of Indifference Curves

5
4

Left Shoes

Notice that two pairs of shoes

would give the consumer more
utility than one pair, and three
pairs more than two. That is why
there are different indifference
curves, each one further towards
the top right of the diagram.

U3

U2

U1

1
0
0

Right Shoes

(b) For perfect substitutes like two bottles of cola sitting next to each other in a store, a
consumer is indifferent to which bottle they buy. They could buy the one on the left, or
the one on the right as long as they have one bottle, they have the same amount of
utility.

Graphically, this looks like a downward-sloping straight line (see below). Either the bottle
on the left is chosen, in which case the bottle on the right is left on the shelf, or vice versa.

Indifference Curve

Left Bottle of Cola

5
4
3
2
1
0
0

Right Bottle of Cola

A whole family of indifference curves can be plotted. For example, when two bottles are
bought, the consumer can buy either two from the left row, two from the right row, or
one from both. This looks like a downward-sloping straight line, where the number of left
and right bottles of cola always sum to two.
This argument generalises to three, four, five bottles etc. Of course, the consumer gains
more utility from two bottles than one, and from three bottles than two. That is why
there are different utility curves, each further towards the top right of the diagram (see
below).

A Family of Indifference Curves

Left Bottle of Cola

5
4
3
2
1

U1

0
0

U2
1

U4

U3
2

U5
4

Right Bottle of Cola

2. Consider pig products and yachts. Draw a set of indifference curves and budget lines like
those in Figure 5A-5 which show pig products as inferior goods and yachts as a luxury
with an income elasticity greater than 1.
Inferior and luxury goods refer to the income elasticity of a good. With an inferior good,
like pig products, people will buy less of them if their income rises. For luxury goods, like
yachts, people will buy more of them when their income rises.

A Family of Indifference Curves

7
6

Bread

5
4
3

U3

For the indifference curves, the

income elasticity of the two
products is irrelevant. The law of
relative
diminishing
marginal
utilities still apply. The second yacht
doesnt make you feel quite so
much of a master of the universe as
the first. You dont enjoy the sixth
bacon sandwich as much as the first.

Therefore you are willing to give up

less pig products for each extra
U1
yacht, as the marginal utility of
0
0
1
2
3
4
5
6
yachts decreases with each new
Shirts
purchase (and vice versa). The
slope, which represents the
substitution ratio between the goods, decreases. Each indifference curve will be
downward sloping and bowl-shaped.
U2

The budget line or budget constraint gives the total amount of the two goods a consumer
could buy if they spent all their money on them. The following must hold:
= +
Rearranging, and letting be , and be the price of yachts and pig
products respectively, and and be the quantity of pig products and yachts
respectively, then:
=

Plotting on a pair of axes, with the quantity of pig products bought on the vertical axis and
the quantity of yachts bought on the horizontal axis, this is a downward-sloping line, with
the slope being the ratio of the prices of the two goods ( ). The budget line NM
(see top of next page) looks this way, as the consumer can buy any combination of the
two goods that fall along this line to spend all their money. They can spend it all on pig
products (at point N), or all on yachts (at point M), or on some combinations of both (along
the line).

If the consumers income

increases, they would
normally buy more of
both goods. The budget
line moves from NM
towards the top right of
the diagram, NM. The
new dashed line is
parallel to the original
line (see right).

Budget Line
80000

N'

For most goods:

70000

Pig Products

60000
50000

40000
30000
20000

But, this is not the case in

this example, as pig
products are an inferior
good a good you buy
less of as your income
rises.

10000

M'

0
0

Yachts

Being an inferior good, less pig products than before will be bought with the higher
income. (Another way of saying it is an inferior good is that it has a negative income
elasticity). N will not be higher up the pig products axis, but lower down. Yachts, being
a luxury, will be bought in a greater proportion than the increase in income, and so M will
be further along the yachts axis than M:

Budget Line
80000

For an inferior
good:

70000

Pig Products

60000

Increased
income

50000
40000

N'

30000
20000
10000

0
0

Increased
income
4

M'
6

Yachts

Superimposing the budget line onto the indifference map:

10

Budget Line
80000
70000

Pig Products

60000
50000
40000

N'

30000

B'

20000

U3

10000

0
0

U2
M'

U1
4

10

Yachts
Consumer equilibrium is attained at the points B and B, where the budget line is tangent
to the highest indifference curve.
At these points, the slope of the indifference curve is equal to that of the budget line. It
has already been found that:

The slope of the indifference curve is equal to the substitution ratio (sometimes
called the marginal rates of substitution) between the two goods, which is the
ratio of the goods marginal utilities :
=

The slope of the budget line is equal to the price ratio of the two goods:
=

Equating the two, as occurs at the consumer equilibrium:

=

This is the same equation derived in Chapter 5 from the equimarginal principle, which
states that a consumer having a fixed income and facing given market prices of goods
will achieve maximum satisfaction or utility when the marginal utility of the last dollar
spent on each good is the same as the marginal utility of the last dollar spent on any
other good. The consumer should spend their income so to get the same marginal
utility per dollar from the last yacht bought as they get from the last pig product.
The geometric analysis derives the same result as the consideration of utility theory.